CHINA´S DOCTORED COPPER DEMAND / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

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MAY 20, 2011, 4:59 A.M. ET

China's Doctored Copper Demand

There is less luster to China's copper demand than meets the eye.

China is the world's largest consumer of copper, much of it imported. But not all of its copper imports are driven by final demand. With credit conditions tight, importing copper has become a way for businesses to circumvent the government's lending controls.

A letter of credit—easier to obtain and cheaper than a bank loan—finances the purchase of copper on the London Metal Exchange. If copper prices are higher in Shanghai than they are in London, the importer can cover transport and storage costs, sell their copper at a profit on the mainland and enjoy the use of the yuan proceeds until the letter of credit expires—typically three months to a year later.

A premium of $210/ton for the three month contract in London over the price in Shanghai throws a wrench in the works for importers. But businesses still can use their copper as collateral for yuan loans and keep the copper in storage hoping that the price differential will move their way. Even if that doesn't happen, demand for credit has been so strong that importers are willing to take a loss on the copper transaction just to get their hands on the cash they need to fund their other operations.

Bonnie Liu, metals analyst at Macquarie, estimates the use of copper to raise financing accounts for more than half of the 550,000 tons sitting in China's warehouses. With copper more than $9,000 a ton for much of the year, that suggests importers could have raised around $2 billion in financing. Compared with $460 billion in new loans in the first four months of the year that isn't a major addition to credit. Still, it points to the difficulty the central bank has in rigorously implementing its tightening monetary policy.

The more significant impact is on copper markets. China's underlying demand for the red metal is strong. A 20% increase in investment in the electricity grid in 2011, and continued strong demand for home appliances as rural households ratchet up their purchases of air conditions and refrigerators mean it is set to remain so.

But purchases currently in warehouse and driven by finance are, using Ms Liu's calculations, equal to around 25% of total imports in the first quarter. If credit conditions stay tight and domestic prices remain low, these importers may find themselves unable to roll themselves out of a dangerous game, and China's demand might not be as copper bottomed as the markets expect.

Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

By TOM ORLIK